Contorted Basis Question

[Corduroy Frog]

First of all, please enjoy Christmas under these strange and unusual circumstances.  I've lost a few friends and hope the vaccine can be distributed to all of us soon.

This question concerns partners' basis and what can happen.  It is a technical discussion, so you may ponder whether you wish to go ahead with it.

Partners A,B,C,and D have been borrowing money with partners' guarantees for a number of years to keep the company afloat.  The company has lost money consistently but is holding out for a brighter future.  The partners all co-sign the loans with joint and several liability, i.e. each or any of them are responsible for the entirety of the loan should the other partner(s) default.  Since partners' guarantees are allowable additions to basis, the basis of each partner is increased in proportion to the their partnership shares for the amounts guaranteed.

In the most recent year, the lender is insisting that some payments be made on the loan.  Partner C is unable to pay his share, so his basis attributable to the loan is split by the other partners in proportion to their remaining shares.  Partner C has been deducting losses on his personal return by virtue of his share of borrowed money.

Question:  What is the effect of the sudden reduction in basis for Partner C?  Is there income in the current year or should amended returns be prepared?  Does he have the classic forgiveness of indebtedness income?

This is difficult reading and stilted language, so it become clear if I put numbers behind the events.

Partner A: 40% with a basis of $40,000.  Guaranteed loans are $150,000 so his basis attributable to the loans is $60,000.  Partner B: 20% with a basis of $20,000.  His basis attributable to the loans is $30,000.

Partner C : 25% with a basis of $25,000.  His basis attributable to the loans is $37,500.

Partner D :  15% with a basis of $15,000.  His basis attributable to the loans is $22,500.  Sorry I can't do anything about the graphics and emoticons showing up as I type.

Partner C cannot pay.  His basis in the loans of $37,500 is removed and split in the ratio of 40:20:15 among the other partners.  This means A's basis is increased by $20,000, Bs basis increased by $10,000 and Ds basis increases by $7500.

After the default by partner C, the new basis for A is $60,000 with $80,000 attributable to loans.  New basis for B is $30,000 with $40,000 attributable to loans.  New basis for D is $22,500 with $30,000 attributable to loan guarantees.

Partner C who defaults loses all his basis, and actually goes into the negative by $12,500.  He previously deducted losses of $3000 in 2017, $5000 in 2018, and $6000 in 2019.

The question becomes:  Does the $12,500 become income in the current year?  If so, is it capital gains or loan forgiveness?  If not income currently, does he have to amend 2018 and 2019 removing the losses claimed in those years?  Is there a 1099-C from the bank or from the partnership?   This is already complicated, so for purposes of this illustration do not consider the insolvency effect to avoid income.

 

 

 

Edited December 25, 2020 by jklcpa
corrected partner references, removed emoticons

[Pacun]

Partner C put down $25K from his pocket for 25% of the shares, correct? If he has used only $14K in losses, he still has $11K basis.

The bank will not issue him a 1099-C because the loan was repaid to the bank.  

Technically he just lost 15% of his interest on the partnership. He only has 10% of interest and this is the way the new interests should be stated:

A gets 48%
B gets 24%
C gets 10%
D gets 18%

[Corduroy Frog]

Pacun, thanks for delving into this.  I'll try to define in answer to you.

Partner C put down $25K from his pocket for 25% of the shares, correct?

There is no evidence that Partner C put down $25K from his pocket.  He may have put in any amount, or may have put in nothing and this could have happened several years ago.  The only facts are that his basis prior to default was $27,500 with loans attributable to $37,500.

The bank will not issue him a 1099-C because the loan was repaid to the bank.

Not stated that the loan was repaid in full, only that the partners were approached and C could not pay anything.

Technically he just lost 15% of his interest on the partnership. He only has 10% of interest and this is the way the new interests should be stated:

You could be right.  Don't know that his default (with no other contributing circumstances) disqualifies him from being a partner or reduces his stated interest unless he is forced out by articles of partnership agreement.  The question only involves his suddenly "overdrawn" basis and how it is handled on his personal return.  Actually, there is also movement in the partners' capital accounts which is different from basis.

This is heavy stuff (especially for people like myself to understand) so I have a feeble mind when thinking about it.  Thank you, Pacun.

 

 

[DANRVAN]

 

On 12/25/2020 at 1:46 AM, Corduroy Frog said:

This is heavy stuff

Apply basic partnership tax rules:

-Partners share of losses are limited to basis at the end of tax year, you do not go back and amend.

-Reduction of partner's share of liabilities is treated the same as a cash distribution.  (sec 752(b)).

-Distributions in excess of basis are income to partner.

[DANRVAN]

On 12/24/2020 at 4:36 PM, Corduroy Frog said:

In the most recent year, the lender is insisting that some payments be made on the loan.  Partner C is unable to pay his share, so his basis attributable to the loan

Are you saying the entire loan was paid or a portion?  Reduce his share only by the amount that was paid by other partners.

[Corduroy Frog]

Thank you Danrvan.  Cleared up my question.  Didn't think of what would happen if only a portion of the loan was paid, but it makes sense that the adjustment in basis would only occur to the extent of the partners' unpaid amount in proportion to what was really paid by the others.  Calculation of basis at year-end means amended returns are not necessary but the entire amount falling out is the same as money received as cash.